High Costs of SEC Approach Would Stymie Success of Crowdfunding, Commenters Warn

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By Yin Wilczek

Feb. 5 --In recent comment letters, small businesses and other industry representatives warned that the Securities and Exchange Commission must lower the costs for issuers and intermediaries if equity-based crowdfunding is to be viable.

Many commenters, including the Small Business Administration's Office of Advocacy, also are questioning the commission's estimated compliance costs for those that may want to offer crowdfunded securities.

Conversely, a far smaller group of commenters--including state securities regulators--urged the SEC to increase investor safeguards by, among other measures, eliminating its proposed issuer safe harbor for “insignificant deviations” from the rules.

Proposed Rules
To implement the Jumpstart Our Business Startups Act, the SEC in October proposed Regulation Crowdfunding, a series of rules that would allow startups and small issuers to raise capital through the online offer and sale of crowdfunded securities .

The SEC's proposal would impose tiered financial disclosure requirements based on three groups of crowdfunded offerings: below $100,000; from $100,000 to $500,000; and above $500,000. Issuers trying to raise $500,000 or more would have to provide, on an ongoing basis, audited financial statements.

According to commission estimates, it would cost issuers about:

• $12,960 to $17,960 for an offering below $100,000;

• $25,460 to $55,460 for an offering between $100,000 to $500,000; and

• $47,960 to $122,960 for an offering above $500,000.


Issuers would not be allowed to raise more than $1 million within a 12-month period.

The comment period for the proposal ended Feb. 3, and the commission's website so far shows that it received more than 250 comments on the rulemaking.

In a Feb. 3 letter, David Burton, a senior fellow from the conservative Heritage Foundation, told the SEC that its estimates “are almost certainly wrong.”

Burton argued that first, the costs incurred by a crowdfunding intermediary in dealing with an issuer--including conducting background screening and establishing a web page for the offering--“do not vary linearly with the offering size.” In addition, Burton said the SEC's estimated costs did not explicitly account for attorneys' fees and accounting fees.

The National Small Business Association also faulted the SEC's estimates, saying the commission “miscalculated the economic costs and administrative burdens” of the proposed rule.

“NSBA suggests that the SEC consider factors such as attorneys' fees and accounting fees as well as more realistic estimates of the amount of time and money it will cost issuers and intermediaries to perform the proposed background screening and ongoing compliance requirements,” it said in a Feb. 3 letter signed by president Todd McCracken.

Meanwhile, the SBA's Advocacy Office warned that the SEC's proposal may be deficient under the Regulatory Flexibility Act. Specifically, the office said the proposal failed to adequately describe the costs that would be imposed on small entities, and failed to include alternatives to minimize the economic impact.

“For this reason, Advocacy recommends that the SEC republish for public comment a Supplemental [Initial Regulatory Flexibility Analysis] before proceeding with this rulemaking,” it said in a Jan. 16 letter. “Advocacy also believes that the SEC should take into consideration small business representatives' suggested alternatives to minimize the proposed rule's potential impact.”

Online funding platform EarlyShares similarly criticized the SEC's figures, saying its market research shows the costs will be higher. In any case, EarlyShares suggested that even under the SEC's numbers, it would cost an issuer--in the five-year life of the investment--between 134 to 154 percent of the offering amount to raise $25,000; between 53 to 65 percent to raise $250,000; between 48 to 63 percent to raise $501,000; and between 24-32 percent to raise $1 million.

“Given these high costs, we are concerned that the proposed rules would create an environment that fosters adverse selection,” it said in a Feb. 3 letter. “Additionally, and equally compelling, we believe that the combination of the expenses and the management time required to fulfill the annual reporting requirements may actually harm the investors” by focusing management's attention on compliance requirements rather than growing the business.

Among other relaxations, small business representatives urged the SEC to streamline and simplify the reporting requirements, eliminate ongoing reporting requirements, and raise to $1 million the threshold at which audited financials would be required. They also called on the commission to allow cash accounting as opposed to requiring issuers to move to accrual accounting.

To keep costs low for funding portals, many commenters suggested, among other recommendations, that the SEC not deem such intermediaries “issuers” that may be held liable for misstatements in connection with the offerings.

Subjecting portals to such liability would result in unintended adverse consequences, such as “insurmountable costs,” said Kiran Lingam, general counsel of SeedInvest LLC, in a Feb. 3 letter.

“A Funding Portal will have to conduct an independent investigation on every statement in every offering document by every issuer in order to limit any potential future liability,” Lingam said. He added that it also would expose the intermediaries to lawsuits, and require them to buy insurance coverage.

Some lawmakers, including Rep. Sam Graves (R-Mo.), chairman of the House Small Business Committee, also have expressed concern that the SEC's proposal would be burdensome for small entities .

Investor Protection
On the flip side, Barbara Roper, director of investor protection at the Consumer Federation of America, suggested in a Feb. 2 letter that given the “huge potential for investor harm,” the proposal would require “substantial revisions” to be “even minimally protective of investor interests.”

Among other changes, Roper urged the SEC to put in place “meaningful procedures” to ensure intermediaries play a bigger role in preventing fraud and ensuring issuer compliance. She also recommended that the commission implement lower investment limits to reduce investor exposure to “devastating” losses.

“It is symptomatic of the Commission's distorted approach to rulemaking, however, that while the Proposing Release asks whether adopting the more investor protective 'lesser of' approach would unnecessarily impede capital formation, it does not ask whether its proposed 'greater of' approach exposes investors to inappropriate risks,” Roper wrote.

The North American Securities Administrators Association also faulted the proposal for not going far enough to protect investors and small businesses in the new regime. Unlike more sophisticated issuers, many small entities may be facing SEC regulatory hurdles for the first time, the state securities organization said in a Feb. 3 letter signed by its president, Ohio Securities Commissioner Andrea Seidt.

“Without regulatory review or clarification by the Commission, issuers and intermediaries may mistakenly believe that the scant amount of disclosure required to qualify for the registration exemption is all the law requires for anti-fraud purposes,” Seidt said. “The Commission could resolve some of the regulatory mystery for these businesses by taking extra steps to educate them on the larger compliance requirements and making fuller disclosure tools available for their use.”

To contact the reporter on this story: Yin Wilczek in Washington at ywilczek@bna.com

To contact the editor responsible for this story: Susan Jenkins at sjenkins@bna.com

The comment letters are available at http://www.sec.gov/comments/s7-09-13/s70913.shtml.